6-1 Capitalized Expenditures  Expenditures which create an asset whose useful life extends beyond the current taxable year must be capitalized  Examples: equipment, buildings, land, patents  Exceptions: R & D costs, advertising costs  Note: Capitalize means to treat a cost as an asset rather than a current expense  In tax lingo, a capital asset is a certain type of asset, with a narrower definition than a capitalized expenditure

6-2 Cost Recovery of Capitalized Expenditures  When is the cost of a capitalized expenditure ‘recovered’ for tax purposes?  Over time?  When the asset is sold?  Other?  How is the cost of a capitalized expenditure recovered for tax purposes?  Permissible cost recovery methods?  Treatment of unrecovered cost on sale?

6-3 Types of Property  Define the following and provide examples of each:  Tangible property  Intangible property  Real property  Personal property

6-4 Initial Tax Basis of Business Assets  General rule: initial tax basis equals purchase price:  Cash paid + debt assumed or incurred + FMV of other property or services given up  Other purchase-related costs also included in initial tax basis:  Sales tax  Freight  Installation charges

6-5 Adjustments to Tax Basis of Tangible Business Assets  Must capitalize the costs of additional expenditures which materially increase the value or extend the useful life of the asset  Repairs vs. capital improvements  Which of the following costs must be capitalized?  Environmental cleanup/asbestos removal  New roof on building  Landscaping costs  Interior remodeling (carpet, partitions, etc.)  Paint

6-6 Adjustments to Tax Basis continued  Adjusted tax basis = Initial tax basis + capital improvements - depreciation/amortization/ depletion allowed or allowable  Adjusted tax basis represents the taxpayer’s unrecovered cost of the asset

6-7 Tax Depreciation under MACRS  WARNING: MACRS rules have changed significantly several times since enacted in Depreciation is determined by the rules in effect for the year in which an asset is placed in service.  The following discussion pertains to rules in effect for assets placed in service since 1993.

6-8 MACRS  Ten recovery periods  Specified by type of property  Usually shorter than useful life for GAAP  Conventions for year placed in service and year of disposition  Mid-year convention for 3- through 20-year property  Midquarter convention if > 40% of depreciable personalty acquisitions occur during final quarter  Mid-month convention for >20-year property  Tax depreciation ignores salvage value

6-9 MACRS Depreciation Methods  200% DB for 3- through 10-year property  150% DB for 15- and 20-year property  Straight-line for >20-year property  IRS tables provide percentages  Table percentages are applied to the asset’s initial tax basis (not adjusted tax basis) to determine each year’s depreciation amount  Mid-year and mid-month conventions for year of acquisition are built into tables  For year of disposition (if before end of recovery life) table percentages must be adjusted

6-10 Tax Basis of Intangible Assets  Costs of self-created intangibles must be capitalized and amortized over time period for which economic benefits expected  Many purchased intangibles subject to IRC. Sec. 197  Amortized on straight-line basis over 15 years  Examples: Goodwill, covenant-not-to-compete, customer-based and workforce intangibles

6-11 Start-up and Organization Costs  Start-up Costs: Pre-operational costs and costing of investigating either the creation or acquisition of a business  Organization Costs: legal, accounting, filing and registration costs related to formation of a new corporation or partnership  Taxpayer may elect to amortize these costs over 60 months, beginning in the first month of operation of an active business

6-12 Mineral Rights  Costs of acquiring mining or drilling rights must be capitalized and are subject to depletion as mineral is removed  Cost =Adjusted Basis * Current production in units Depletion Estimated total units of production  Percentage Depletion = Gross Income * Statutory Rate  Greater of cost or percentage depletion for taxable year is deductible (property-by-property)

6-13 Current Deductions of Capital Expenditures  Sec. 179 (Limited Expensing) Election – NEW LAW CHANGES  $100,000 ( ) of tangible personal property costs deductible in year of acquisition  Phased out for taxpayers with annual property expenditures > $400,000  Currently deductible amount limited to taxable business income before this deduction  Post-Sept. 11 additional first year depreciation  Applies to tangible personal property, computer software and leasehold improvements  30% of cost deductible in year of acquisition for acquisitions after 9/11/01 and before 5/6/03  50% of cost deductible in year of acquisition for acquisitions after 5/5/03 and before 1/1/05 (NEW LAW CHANGE)

6-14 Current Deductions of Capital Expenditures continued  Costs of removal of barriers to handicapped access ($15,000 annual maximum)  Soil and water conservation expenditures by farmers  Research and experimentation costs  Advertising  Costs of environmental remediation at targeted contamination sites  Intangible Drilling Costs

6-15 Tax Incentives Example: Oil and Gas Drilling and Development  Independent oil and gas companies receive two important tax incentives:  Current deduction for intangible drilling costs  Percentage depletion (15% of gross revenue)  Why are these favorable tax breaks offered? Without them, the riskiness of oil and gas exploration would deter many companies from investing in this activity

6-16 Example 1: Oil and Gas Incentives  Assume drilling costs of $100,000 for a well expected to produce 2,500 barrels of oil annually for 5 years. Current oil prices are $18 per barrel, and expected operating costs for the well are $6 per barrel. Assume a marginal tax rate for the independent producer of 34%, and a 7% discount rate.

6-17 Example 1 continued  Without special tax incentives to promote exploration, drilling costs would be capitalized and depleted, using cost depletion, over the productive life of the well.  Annual gross revenue$45,000 Annual operating costs 15,000 Annual depletion 20,000 Net taxable income 10,000 Annual tax cost 3,400 Annual after-tax cash flow 26,600  PV of 5 year after-tax returns$109,065 Rate of Return on investment 9%

6-18 Example 1 continued  By allowing immediate expensing of drilling costs, the return on this investment increases significantly.  Annual gross revenue$45,000 Annual operating costs 15,000 Annual depletion 0 Net taxable income 30,000 Annual tax cost 10,200 Annual after-tax cash flow 19,800  PV of 5 year after-tax returns $81,184 Tax benefit in year 1 from drilling cost deduction 34,000 Total NPV$115,184  Rate of Return on investment 15%

6-19 Example 1 continued  By also allowing percentage depletion of 15% of annual gross revenue, the return on this investment more than doubles from the non- tax-favored return.  Annual gross revenue$45,000 Annual operating costs 15,000 Annual depletion 6,750 Net taxable income 23,250 Annual tax cost 7,905 Annual after-tax cash flow 22,095  PV of 5 year after-tax returns $90,594 Tax benefit in year 1 from drilling cost deduction 34,000 Total NPV $124,594  Rate of Return on investment 25%

6-20 Incorporating Cost Recovery into NPV Analysis  Initial cost of asset results in cash outflow  If acquired with debt, cash outflows occur for debt principal and interest payments  Tax savings generated by interest expense represents a cash inflow  Depreciation expense is not a cash outflow  Tax savings generated by depreciation expense represents a cash inflow

6-21 Accounting for Inventories  Must use accrual method - only cost of goods sold (COGS) is deductible  Two issues in determining COGS:  Product versus period costs (which costs are inventoriable)  Manufacturers and large retailers/wholesalers must determine inventory cost (product cost) for tax purposes using uniform capitalization rules, which are NOT consistent with GAAP  Allocation of costs to goods on hand versus goods sold (cost flow assumptions):  Specific identification, FIFO, LIFO  LIFO conformity requirement

6-22 Tax Implications of Asset Acquisitions: Planning Issues  The after-tax cost of an asset acquisition increases as the recovery life (period of time over which the asset’s cost may be deducted for tax purposes) increases  Leveraged financing of asset purchases, where the cost of the asset is financed over a period longer than the recovery period, can decrease the after-tax cost of an acquisition

6-23 Planning Issues continued  Another alternative: Lease vs. purchase  Tax treatment of leases:  Generally, annual lease payments are deductible  Up-front payments to acquire a lease must be capitalized and amortized over lease term  Some leases may be treated as purchases for tax purposes, depending on facts

6-24 Update to Book/Tax Difference List Temporary Differences Differences in inventoriable costs under Unicap rules Differences between book and tax depreciation/ amortization/depletion Sec. 179 (immediate expensing) deduction Intangible drilling costs (full cost method for GAAP) Deductible R&D costs Permanent Differences Percentage depletion in excess of investment